BOND MARKET CHAPTER

AN-NAJAH
NATIONAL UNIVERSITY

Faculty of Economics and
Administrative Sciences
Department of Finance

Financial Markets
Course Code 51458

Chapter 12
The Bond Market
Dr. Muath Asmar

Chapter Preview

In this chapter, we focus on longer-term
securities: bonds. Bonds are like money
market instruments, but they have maturities
that exceed one year. These include
Treasury bonds, corporate bonds,
mortgages, and the like.

© 2012 Pearson Prentice Hall. All rights reserved. 12-2

Chapter Preview
We examine how capital markets operate, and then
focus our attention on the bonds and the bond
market. We will conclude this topic with Chapter 14
on mortgages. Topics include:
Purpose of the Capital Market
Capital Market Participants
Capital Market Trading
Types of Bonds
Treasury Notes and Bonds


Chapter Preview (cont.)
 Municipal Bonds
 Corporate Bonds
 Financial Guarantees for Bonds
 Current Yield Calculation
 Finding the Value of Coupon Bonds
 Investing in Bonds


Purpose of the Capital Market
 Original maturity is greater than one year,
typically for long-term financing or
investments
 Best known capital market securities:
─ Stocks and bonds


Capital Market Participants
 Primary issuers of securities:
─ Federal and local governments: debt issuers
─ Corporations: equity and debt issuers
 Largest purchasers of securities:
─ Individuals


Capital Market Trading

1. Primary market for initial sale (IPO)
2. Secondary market
─ Over-the-counter
─ Organized exchanges (i.e., NYSE)


Types of Bonds
 Bonds are securities that represent debt
owed by the issuer to the investor, and
typically have specified payments on
specific dates.
 Types of bonds we will examine include
long-term government bonds (T-bonds),
municipal bonds, and corporate bonds.


Types of Bonds:
Sample Corporate Bond


Treasury Notes and Bonds
 The U.S. Treasury issues notes and bonds
to finance its operations.
 The following table summarizes the
maturity differences among the various
Treasury securities.


Treasury Notes and Bonds


Treasury Bond Interest Rates
 No default risk since the Treasury can print
money to payoff the debt
 Very low interest rates, often considered
the risk-free rate (although inflation risk is
still present)


 The next two figures show historical
rates on Treasury bills, bonds, and the
inflation rate.


Treasury Bond Interest Rates:
Bills vs. Bonds


Treasury Bonds:
Recent Innovation
 Treasury Inflation-Indexed Securities:
the principal amount is tied to the current
rate of inflation to protect investor
purchasing power
 Treasury STRIPS: the coupon and principal
payments are “stripped” from a T-Bond and
sold as individual zero-coupon bonds.


Treasury Bonds: Agency Debt
 Although not technically Treasury
securities, agency bonds are issued by
government-sponsored entities, such as
GNMA, FNMA, and FHLMC.
 The debt has an “implicit” guarantee that
the U.S. government will not let the
debt default. This “guarantee” was clear
during the 2008 bailout…


The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
 Both Fannie and Freddie managed their
political situation effectively, allowing them
to engage in risky activities, despite
concerns raised.
 By 2008, the two had purchased or
guaranteed over $5 trillion in mortgages or
mortgage-backed securities.


The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
 Part of this growth was driven by their
Congressional mission to support
affordable housing. They did this by
purchasing subprime and Alt-A mortgages.
 As these mortgages defaults, large losses
mounted for both agencies. The final
outcome remains unknown.


Municipal Bonds
 Issued by local, county, and
state governments
 Used to finance public interest projects
 Tax-free municipal interest rate = taxable
interest rate × (1 − marginal tax rate)


Municipal Bonds: Example

Suppose the rate on a corporate bond is 9%
and the rate on a municipal bond is 6.75%.
Which should you choose?
Answer: Find the marginal tax rate:
6.75% = 9% × (1 – MTR), or MTR = 25%
If you are in a marginal tax rate above 25%,
the municipal bond offers a higher after-tax
cash flow.

Municipal Bonds: Example

Suppose the rate on a corporate bond is 9%
and the rate on a municipal bond is 6.75%.
Which should you choose? Your marginal tax
rate is 28%.
OR Answer: Find the equivalent tax-free rate:
ETFR = 9% × (1 – MTR) = 9% × (1 – 0.28)
The ETFR = 6.48%. If the actual muni-rate is
above this (it is), choose the muni.

Municipal Bonds
 Two types
─ General obligation bonds
─ Revenue bonds
 NOT default-free (e.g., Orange County
California)
─ Defaults in 1990 amounted to $1.4 billion in
this market


Municipal Bonds

The next slide shows the volume of general
obligation bonds and revue bonds issued
from 1984 through 2009.
Note that general obligation bonds represent
a higher percentage in the latter part of the
sample.


Municipal Bonds: Comparing Revenue
and General Obligation Bonds


Corporate Bonds
 Typically have a face value of $1,000,
although some have a face value of $5,000
or $10,000
 Pay interest semi-annually


Corporate Bonds
 Cannot be redeemed anytime the issuer
wishes, unless a specific clause states this
(call option).
 Degree of risk varies with each bond, even
from the same issuer. Following suite, the
required interest rate varies with level
of risk.


Corporate Bonds
 The next slide shows the interest rate on
various bonds from 1973–2009.
 The degree of risk ranges from low-risk
(AAA) to higher risk (BBB). Any bonds rated
below BBB are considered sub-investment
grade debt.


Corporate Bonds: Interest Rates


Corporate Bonds: Characteristics
of Corporate Bonds

 Registered Bonds
─ Replaced “bearer” bonds
─ IRS can track interest income this way
 Restrictive Covenants
─ Mitigates conflicts with shareholder interests
─ May limit dividends, new debt, ratios, etc.
─ Usually includes a cross-default clause


of Corporate Bonds

 Call Provisions
─ Higher yield
─ Mechanism to adhere to a sinking fund provision
─ Interest of the stockholders
─ Alternative opportunities
 Conversion
─ Some debt may be converted to equity
─ Similar to a stock option, but usually more limited


of Corporate Bonds

 Secured Bonds
─ Mortgage bonds
─ Equipment trust certificates
 Unsecured Bonds
─ Debentures
─ Subordinated debentures
─ Variable-rate bonds


of Corporate Bonds

 Junk Bonds
─ Debt that is rated below BBB
─ Often, trusts and insurance companies are not
permitted to invest in junk debt
─ Michael Milken developed this market in the
mid-1980s, although he was subsequently
convicted of insider trading


Corporate Bonds: Debt Ratings

The next slide explains in further details the
rating scale for corporate debt. The rating
scale is for Moody’s. Both Standard and
Poor’s and Fitch have similar debt
rating scales.


Corporate Bonds: Debt Ratings (a)


Corporate Bonds: Debt Ratings (b)


Financial Guarantees for Bonds
 Some debt issuers purchase financial
guarantees to lower the risk of their debt.
 The guarantee provides for timely payment
of interest and principal, and are usually
backed by large insurance companies.


Financial Guarantees for Bonds
 As it turns out, not all guarantees actually
make sense!
─ In 1995, JPMorgan created the credit default
swap (CDS), a type of insurance on bonds.
─ In 2000, Congress removed CDSs from any
oversight.
─ By 2008, the CDS market was over $62 trillion!
─ 2008 losses on mortgages lead to huge
payouts on this insurance.


Bond Yield Calculations
 Bond yields are quoted using a variety of
conventions, depending on both the type of
issue and the market.
 We will examine the current yield
calculation that is commonly used for
long-term debt.


Bond Current Yield Calculation

What is the current yield for a bond with a
face value of $1,000, a current price of
$921.01, and a coupon rate of 10.95%?
Answer:
ic = C / P = $109.50 / $921.01 = 11.89%
Note: C ( coupon) = 10.95% × $1,000 =
$109.50


Finding the Value of Coupon
Bonds
 Bond pricing is, in theory, no different than
pricing any set of known cash flows. Once
the cash flows have been identified, they
should be discounted to time zero at an
appropriate discount rate.
 The table on the next slide outlines some of
the terminology unique to debt, which may
be necessary to understand to determine
the cash flows.

Bonds


Bonds

Let’s use a simple example to illustrate the
bond pricing idea.
What is the price of two-year, 10% coupon
bond (semi-annual coupon payments) with a
face value of $1,000 and a required rate of
12%?


Bonds
Solution:
1.Identify the cash flows:
─ $50 is received every six months in interest
─ $1000 is received in two years as principal repayment

1.Find the present value of the cash flows (calculator
solution):
─ N = 4, FV = 1000, PMT = 50, I = 6
─ Computer the PV. PV = 965.35


Investing in Bonds
 Bonds are the most popular alternative to
stocks for long-term investing.
 Even though the bonds of a corporation are
less risky than its equity, investors still have
risk: price risk and interest rate risk, which
were covered in chapter 3


Investing in Bonds
 The next slide shows the amount of bonds
and stock issued from 1983 to 2009.
 Note how much larger the market for new
debt is. Even in the late 1990s, which were
boom years for new equity issuances, new
debt issuances still outpaced equity by over
5:1.


Investing in Bonds


Chapter Summary
 Purpose of the Capital Market: provide
financing for long-term capital assets
 Capital Market Participants: governments
and corporations issue bond, and we
buy them
 Capital Market Trading: primary and
secondary markets exist for most securities
of governments and corporations

Chapter Summary (cont.)
 Types of Bonds: includes Treasury,
municipal, and corporate bonds
 Treasury Notes and Bonds: issued and
backed by the full faith and credit of the
U.S. Federal government
 Municipal Bonds: issued by state and local
governments, tax-exempt, defaultable.


 Corporate Bonds: issued by corporations
and have a wide range of features and risk
 Financial Guarantees for Bonds: bond
“insurance” should the issuer default
 Bond Current Yield Calculation: how to
calculation the current yield for a bond


 Finding the Value of Coupon Bonds:
determining the cash flows and discounting
back to the present at an appropriate
discount rate
 Investing in Bonds: most popular alternative
to investing in the stock market for long-
term investments


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